Fraud in the Financial Markets: Are You Vulnerable?

Fraud in the Financial Markets: Are You Vulnerable?

In today's edition, I'll discuss the conditions which make the financial industry a perfect breeding ground for crooks and scammers - the explanation isn't as simple as the old-fashioned excuse of greed. Then I'll discuss a hot, new type of bond. If you're searching for yield, this is a must-read article.

Before we get started, I also want to let you know about Casey Research Chief Economist Bud Conrad's upcoming appearance at the Sovereign Society Global Currency Expo in San Diego, CA from April 5-7. It should be a particularly interesting conference, especially considering the strange dynamic in today's markets. The Federal Reserve continues to ease incessantly, yet the dollar has stood its ground... but no one knows how long will it manage to do so. These are definitely times when you need all the expert information you can get when it comes to currencies. So, if you're around San Diego in April, make sure to go check out Bud and the other excellent speakers.

Now, let's get to discussing crooks in financial markets...

arrest of Florian Homm, a German hedge fund manager on the run for five years. He is accused of cross trading shares of stocks between his company's funds, which boosted their value. This in turn generated more fees for his firm and artificially increased the value of its shares. Of course, the world of finance isn't the only place to find crooks. No profession is safe. From unethical plagiarists to artists reproducing forgeries to doctors scamming insurance companies, if you live long enough, you will see it all.

Nonetheless, it's hard to ignore that there is a steady stream of crooks in the financial news. It seems that almost every few months some new, small-time Bernie Madoff is busted for one thing or another. What gives? Often the blame falls on "greedy businessmen," but in my opinion, there are intrinsic problems in the asset-management industry that helps crooks thrive:

1. You can make a fortune by simply being lucky. Asset management is one of the only industries where you can become a multimillionaire simply through luck. This is a statistically provable fact. If you track the investment performance of 10,000 people who know nothing about stocks and trading, some of them will become millionaires by sheer dumb luck.

Worse, those lucky winners will typically convince themselves that they have some sort of special insight. Hence, they will sound genuine when selling their investment ideas.

There's no other profession like this. For example, one can't be a lucky brain surgeon. If one is a complete quack who learned nothing in medical school, one will inevitably kill somebody and get booted from the profession. You can't just get lucky from surgery to surgery. As a result, in other professions, the bad apples are weeded out fairly quickly. However, in the financial sector, it's quite possible for someone to be a multimillionaire and a complete imbecile when it comes to finance.

From the pool of lucky winners, you have the perfect combination to breed deception: access to lots of money; a track record of success; and an inability to actually earn returns through skill. Managers who earned their money don't need to cheat their clients. But unfortunately, lady luck opens the industry's door to the incompetent, who may become crooks when the luck runs out.

2. Rising waters lift all ships. Sure, you can make a fortune in the stock market simply by luck. But why make a fortune when you can also do well by doing just good enough? In a rising market, one can almost pick any random stock and do pretty well - maybe a few points more than the market or maybe a few points below the market. One could know very little about the stock market and make some random picks, and do all right at the least.

Rising markets help protect fraud from being revealed. Since nearly everyone is making money, the industry competition fails to eliminate the incompetent and the fraudulent. Notice that most crooks are exposed when the markets turn sour. That condition is part of the reason - it's much easier to run a scam in favorable markets. If you're a very likable con man and promoter, you can attract a lot of people to your fund while letting the market do most of the work for you. One can be very good at raising funds and talentless at stock picking and still eke out an incredibly good living in this business. But once things hit the fan, raising money becomes impossible, and stock picking and making wise moves turns out to be what matters.

What's most likely is some combination of items one and two. Statistically speaking, it's difficult to get lucky nonstop. But how about having a few really good years followed by a bunch of average ones? On Wall Street, one can make a whole career of doing precisely that.

3. As long as there's money flowing, most investors are completely blind. A friend of mine recently got into a horrible business deal that went wrong. To make a long story short, there is fraud, courts, lawyers, and missing money involved. How did he get into this bad deal? Essentially, the same guy made him nearly a million dollars in a previous deal, which was an almost 300% return. At the time, I had pointed out to my friend improprieties in the relationship. Instead of making a million, he should have made $1.3 million were it not for some dumb and questionable mistakes by his partner.

Of course, my friend would not listen to me. His partner had just made him a million dollars - that's all he needed to know. So even though I plainly showed him his partner's incompetence and reliance on luck, he went ahead on a second deal with him. In hindsight, his partner was doing fine in a rapidly rising market that helped disguise his fraud and cluelessness. When the market crashed on the next deal, everything came out of the woodwork. If someone is making us good money, many people couldn't care less about the specific operational details or the strategy. Such indifference to red flags is the dream of a financial crook.

4. People forget every lesson taught in business school. If someone is making money or has previously earned money in the past, it's easier to ignore everything learned in business school finance courses. Similar to item number three, we are willing to believe anything from a wealthy person. "So you doodle lines on a chart of the S&P 500, and you can predict the way the market is heading. Sounds kind of fishy... but since you have so much money, I guess it must work."

I find it shocking how many stock pickers out there just say off-the-wall, wacky stuff that would get them an F in any finance course. Again, this happens in no other profession. If you asked a surgeon to find a kidney and he pointed to the heart, most of our jaws would drop in shock. In finance, the response depends. If he's a rich hedge fund manager, he could convince investors based on his wealth and past track record that a "heart" really is a "kidney." Not only would many fall for such an incredulous statement, but some would actually place him on a pedestal for his unconventional "analysis" and deep "insight." This sort of thing happens all the time.

These four elements help fraud go a lot further than in most professions. And it's hard for us to resist some of these scams. How many people will look into the details and fire an asset manager who just earned them 75% returns, when maybe the return should have been 80%? Who can stand up to a super-wealthy fund manager and accuse him of being a charlatan based on financial theory? This is exactly happened with the Bernie Madoff scandal, as his consistent returns were practically impossible. The case was laid out in front of the SEC. Nobody listened - after all, Bernie was a super-successful investor.

It can be hard for investors to defend themselves, especially because we judge other professions similarly. You go to a doctor with a good reputation for helping patients; you don't assume that he was lucky. But in finance, someone with a good reputation might - believe or not - just be lucky, or worse yet, fraudulent.

My advice for avoiding many problems is simple: don't focus on someone's net worth for your investment decisions. Instead, consider their ideas and pretend that you heard them from the intern just starting his first day on the job. Does the idea still sound like a logical and reasonable investment plan? If so, then you should go for it; but if you're following advice on blind faith, you're potentially setting yourself up for disaster.

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